How your Cash Flow Keeps You in Debt

Cash Flow Diagram of Debtors

(This is the second post in a series on cash flow. The first post in the series is located here.)

A very important step in personal financial planning is to create a cash-flow diagram as seen above, and as described in the previous post, to understand where your money is going. The one above is a yearly diagram, in that it has income and expenses for the year listed. That is the best first diagram to make since it smooths out the odd months with extra paychecks or big expenses. It also can become the basis for your yearly and monthly budgets. Today we’ll look at one cash flow diagram that is typical of an American middle-class family.

The yearly cash flow diagram shown in the figure above is typical for many middle-class families (click the figure to get a better look), and also shows why many families go into debt despite seeing millions of dollars pass through their bank accounts during their lifetimes. Note that they have a good household income, totaling $100,000 per year after taxes, since they have two middle-class workers in the household. Still, because of they way they have their cash flow setup, they will perpetually go deeper and deeper into debt. To understand why, let’s see where the money goes after it comes into their home as it flows through their cash flow diagram.

First it stops in their bank account, which usually has about $3,000 in it, giving them some piece of mind that they have some emergency cash on hand. A bunch of their money then flows over to their Obligated Expenses in Box C, which are things they must pay for each month or face fees, fines, and foreclosures. Here they have a $14,400 per year mortgage, which really isn’t bad considering they have a $100,000 per year income, so they didn’t overspend on the home. (A good rule is to keep your mortgage payment at less than 25% of your take-home pay.) They also have student loan payments totaling $13,000 per year, however, and two car loans totaling over $14,000 per year. The total for their obligated expenses, which are things they must pay or face fines and penalties, is $45,800, taking almost half of their income. They would be in better financial shape if they had paid off the student loans before buying a house. Another smart move would have been to put $5000 into a couple of old but reliable used cars and saved the car payment. Even if they put $2,000 in repairs into the cars each year, they would be way ahead of the game. They would also be growing their wealth instead of going into debt.

Moving onto Box D, Necessary Expenses, we see that they spend quite a bit on food each year ($12,000). While this may seem excessive, this is just due to a $200 per month grocery bill and five meals out per week at $40 per meal. Many families easily exceed this since they often eat out and $40 for a family is really cheap. They could cut back on eating out to maybe once per week and cut this bill to under $5,000 per year, however. They also spend a healthy amount on clothing, cell phones under “utilities,” and an “other” category that covers all of the stuff they buy for the home, car, work, and yard throughout the year. This results in necessary expenses of $40,700 per year, which combined with obligated expenses eats up about 86% of their income. If they were to cut back on some of these categories by making some better choices, they would have more left over to save and invest.

We now move to the luxuries in Box E, Optional Expenses, which is what pushes them over the top into debt since they buy extras without watching their budget. Here we see that they don’t scrimp on vacations – gotta live while you’re young – at $10,000 per year for a couple of resort visits with airfare. They also spend a lot of money on ball games, movies, and other forms of entertainment during the year, resulting in an entertainment cost of $6,000 per year or about $500 per month. They also spend about $300 per month on lattes and other things they can’t quite remember in their “Spending Cash” category. In total, luxuries total almost $25,000 per year when though they only have $14,000 to spend after obligated and necessary expenses.

So, while they make a great income, they still spend over $11,000 per year more than they make. This means that they would go into debt this first year, then go deeper and deeper into debt as they go unless they cut back on spending. This might start as credit cards and then be refinanced into a home equity loan, which would become a new obligated expense. As their debt grows, they would start paying interest payments, which would be cause their obligated expenses to increase even more than just repaying the debt would, making their cash flow situation worse. It is possible that they may be able to stop the growth of their debt if they can get their income up during these early years (they still have college loans outstanding, so I’m assuming that maybe they just got out of college and are just starting new jobs) enough to offset their spending and make their budget balance, but even then any emergency like a needed home or car repair or trip to the emergency room would upset the balance and send them deeper into debt because they don’t have enough of a surplus at the end of most months to build up their cash-in-hand in Box B that they could then use for unexpected expenses. Without having a cash cushion, they would need to use debt and without any surplus income it would be difficult to pay that debt back.

Note also that there is no money going into Required Investing, Box F, meaning that they will not have any money for college for their children, retirement, or even home repairs and their next new car. There certainly is no money going into Box G, Saving and Investing. In fact, they are pulling money out of investments that they don’t have to cover their over spending. This means that they will never generate any investment income to increase their income in Box A. In fact, they will create interest payments that will add to their obligated expenses in Box C as previously noted.

Sadly, this is a cash flow diagram typical of middle class families. They have a great income, but they spend a little more than they have, causing themselves to go into debt over time. As the interest on that debt grows, the amount of overspending also grows since now they must also pay the interest on the debt. Before long, the debt becomes unbearable, resulting in bankruptcy. Even if it never gets to that extreme, it still takes away a lot of the income the family makes.

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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